The Saudi side's resilience, led by an inspired performance from goalkeeper Yassine Bounou and a late winner from Marcos Leonardo, sent shockwaves through the tournament.
Manchester City, heavy favorites, struck first in the ninth minute when Bernardo Silva tapped in after Ilkay Gundogan blocked a clearance, sparking protests from Al Hilal over a potential handball.
The goal stood after a quick VAR review, but Bounou's heroics kept City at bay. The Moroccan goalkeeper denied Erling Haaland's header and produced stunning reflex saves to thwart Savinho and Jeremy Doku before halftime.
Al Hilal roared back after the break, flipping the game within seven minutes. Marcos Leonardo equalized, scrambling in a cross City failed to clear, before Malcom raced from his own half to slot past Ederson for a 2-1 lead.
Haaland responded for City, blasting home an equalizer on 55 minutes after a poorly defended corner.
The end-to-end chaos continued as Al Hilal thought they had a penalty, only for an offside call to deny them. With both teams tiring, Ali Lajami's goalline clearance stopped Haaland from snatching a late winner, forcing extra time.
In extra time, Kalidou Koulibaly's towering header from Ruben Neves' corner restored Al Hilal's lead. City hit back instantly through Phil Foden, who rifled in a first-time shot from Rayan Cherki's pinpoint cross.
But Al Hilal landed the decisive blow in the 113th minute when Ederson's brilliant save on Sergej Milinkovic-Savic fell to Leonardo, who bundled the ball home to secure a quarter-final clash with Fluminense.
Guardiola admitted Manchester City lacked ruthlessness. "We had to be clinical," he said. "They didn't create much in the first half, but we couldn't finish our chances. The margins are minimal in this competition."
Despite the defeat, he praised his squad's efforts: "The vibe was good, the training sessions were excellent, and Bernardo, our captain, led well. We saw many positive things."
Looking ahead to the Premier League, Guardiola urged his players to recharge. "It's a pity we couldn't go further," he said. "This tournament comes once every four years. Now we go home, rest our minds, and prepare for the new season."
Recent posts on X from Manchester City's official account expressed disappointment but highlighted the team's focus on the upcoming Premier League campaign, echoing Guardiola's call for a mental reset.
Al Hilal's account celebrated the "historic" victory, with Bounou praised as a "wall" by fans. Marcos Leonardo, in a post-match X update, dedicated the win to Al Hilal's supporters, saying, "This is for you, we fight until the end."
The result marks a seismic moment in the Club World Cup, with Al Hilal proving they can topple giants. Manchester City, meanwhile, return home to regroup, their sights set on domestic glory.